PERs in practice - Part 2

In the second of our series on PERs, we talk about adjusting for significant items.

In Part 2, our hunt for the 'real' earnings per share (EPS) figure, which forms the important 'E' in PER, will take us into a more controversial area - abnormal, or 'significant' items, as they are now referred to.

Significant items

Current accounting standards define 'significant' items as those which are included in ordinary activities but which are large and/or unusual. Examples include litigation settlements, inventory writedowns and restructuring costs (read sacking people and shutting down divisions). Let's use an analogy to set the scene for further discussion.

Profits are the economic equivalent of calories - the more a company consumes the fatter its shareholders' bank accounts become, which is a good thing. So rather than consume fewer calories as a conventional dieter would, the ultimate corporate diet includes as many 'calories' or profits as possible.

Even disciplined people on strict diets indulge in the odd piece of chocolate occasionally. Similarly, every now and again the best of companies slip up and lose chunks of shareholders' cash.

And just as a dietician would be faced with the task of assessing whether a client's 'binge' is a one-off or a recurring habit, we as investors are faced with the prospect of classifying a corporate 'binge', or loss, in a similar fashion.

So how can you tell whether the significant item you're considering is a genuine one-off? That is the $64,000 question.

Case-by-case

It's a matter of judgment. You have to look closely at the nature of the item on a case-by-case basis. In general, wishy-washy 'provisions' or 'writedowns' arouse our suspicion more than, say, litigation settlements (assuming the company isn't a courtroom regular).

At Intelligent Investor we're inclined to mark companies guilty until proven innocent. So we hardly bat an eyelid when some companies add yet another write down to their seemingly endless list of 'one-off' significant items, like News Corporation or AMP. In human terms, they have a serious eating disorder.

A company like Flight Centre, however, is a good corporate citizen here. Australia's largest travel retailer hasn't made a habit of springing 'one-offs' on its shareholders. And that's how we like it.

Call us unadventurous but we hate surprises in the stockmarket. Experience has taught us that in the majority of cases they are of a red rather than black ink variety.

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